Pressure Grows on ECB To ‘Do Something’

The question is, what can it do that might be in the least bit effective? After all, by some calculations, interest rates for some parts of the single currency region need to be as low as minus 15% to match their economic circumstances.

After the summer’s brief flurry of euphoria that the euro zone might finally be recovering, an autumn gloom has settled with every subsequent recent data release. Most worrying are that the region’s unemployment levels are at record highs, while inflation has been heading ever lower.

The falling inflation rate especially raises concerns that the single currency region is slipping into a Japan-style deflationary spiral.

These deflationary pressures have been made worse by the euro’s steady appreciation, which in effect represents a monetary tightening.

And monetary tightening is the last thing the euro zone needs right now.

But unlike Japan, which from about a year ago rolled out massive fiscal and monetary stimulus programs, in part designed to lift the economy out of deflation through a yen devaluation, the European Central Bank is limited in the sort of monetary policy measures it can pursue to force the euro’s value down.

For one thing, the sort of massive bond-buying measures other central banks have pursued–quantitative easing–is off the agenda for political reasons. Indeed, while other central banks have been expanding their balance sheets, the European Central Bank’s has been contracting not least because of private sector credit contraction in major single currency economies like Italy.

There has been some talk about a quarter point cut in the ECB’s key refinancing rate, which would take it to 0.25%. But this is a “Band-Aid on a shotgun wound,” argues Kit Jukes, global strategist at Societe Generale.

By Taylor Rule calculations, a rough-and-ready reckoner on where interest rates should be based on inflation, unemployment and an estimate of the economy’s potential, economic conditions in countries like Ireland, Spain and Portugal warrant deeply negative interest rates. Rates as low as minus 15% in the case of Greece, according to estimates made in September by Bruegel, a Brussels-based economics think-tank.

Of course the ECB isn’t making policy just for Greece or the region’s weakest economies. Nonetheless, the average interest rate for the whole of the euro zone should still be negative–around minus 2%–based on region-wide data, according to Mr. Jukes.

Could the ECB deliver a negative interest rate?

Its president, Mario Draghi, says it can. It’s a rare measure, but it has been done by countries like Switzerland in the past when they’ve faced overwhelming capital inflows. A negative rate would certainly go a long way to halting the euro’s appreciation, though it would create its own problems, not least political ones.

More likely is another long term refinancing operation designed to pump liquidity into banks. To get the banks lending the money on, the ECB could well consider something like the U.K.’s Funding for Lending scheme which gives banks access to cheap central bank funding on condition the money is lent back out into the economy. On the other hand, one of the few good pieces of euro-zone economic news recently was a survey showing that banks are loosening their credit conditions. Credit demand rather than supply is more the problem.

Whatever the ECB does, it’s unlikely to be enough on its own. One of the big structural problems with the single currency region is Germany’s large current account surplus and insufficient domestic demand. This imbalance is a key driver of euro-zone deflation. But so too are demographics–the region’s aging population–which is beyond the short-term control of either politicians or central bankers.